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Hungry for Whole Foods

The nasty recession forced consumers to trade down en masse, flocking to Wal-Mart (WMT) and discount dollar stores and shunning pricey stores like Whole Foods Market (WFMI). But on Aug. 5, after the organic and natural foods supermarket chain said conditions are looking better, investors flocked to the stock, sparking a 16% jump to 28.70.

For the first time in a year and a half, Whole Foods reported a rise in same-store sales from the previous quarter. Identical-store sales still fell 3.8% year-over-year, but that's much better than the 5.8% slide the previous quarter. Whole Foods beat profit expectations, posting earnings on Aug. 4 of 28¢ per share, compared with the 20¢ analysts were expecting.

Whole Foods executives sounded upbeat, a rare phenomenon among grocery execs these days. "You could take this as an early indicator that maybe the economy is getting better if Whole Foods has firmed up some," Chairman and Chief Executive John Mackey told analysts Aug. 4. "But," he added, "we don't really know."

Whole Foods execs said they're seeing a slight uptick in traffic and in the number of items those customers buy. "It's signs of momentum. It's signs of stability," co-President Walter Robb said, "but it's too early to call where this is going."

Fierce Supermarket Competition Whole Foods has been able to boost profit margins at a time when many other supermarket chains, including giants like Kroger (KR), have the opposite problem, says BB&T Capital Markets (BBT) analyst Andrew Wolf. The competition among supermarkets is fierce, and conventional grocery stores have slashed prices to try to hold on to customers. Whole Foods, which started losing customers earlier than most, may have stabilized earlier too, Wolf says. "The worst is over for their customer attrition," he says. "Their core customer is likely sticking with them."

At the same time, Whole Foods "really attacked the inefficiencies in their business," Canaccord Adams analyst Simeon Gutman says.

In 2008, when the U.S. economy began to plunge into recession and consumers slashed spending, Whole Foods felt the pain. Its same-store sales were the worst in the supermarket industry, Wolf says. Its stock fell from almost 40 at the end of 2007 to less than 10 at the end of 2008, a 76% decline.

But now, Whole Foods is the top-performing retailer of 2009. And since the beginning of the year, Whole Foods' shares are the fourth-best performer in the S&P 500, according to data provider Capital IQ. Following their Aug. 5 rally, Whole Foods shares have soared 204% for the year.

"Not a High-Income Retailer" That's an impressive performance in a recession from a retailer specializing in expensive, high-quality products. Whole Foods has tried to offer more discounts in an effort to change its image for cost-conscious consumers.

But Mackey insists it doesn't market to an "upper-income customer" like some other premium retailers. "It's not income that drives our business. It's education," he says. "One of the reasons Whole Foods Market has held up fairly well compared to other so-called high-income retailers is because maybe we're not a high-income retailer. We're a retailer that markets to well-educated people who tend to want to continue to buy these foods regardless of the downturn."

Loyal customers may be sticking with Whole Foods, but analysts say a real rebound for Whole Foods—and a return to its previous rapid growth—will need to wait for a rebound in the broader economy. Right now, "we are seeing stabilization, maybe the glimmer of some signs of life," Gutman says. But, "I don't think you can say things have materially improved."

Along with the tough environment, the fact that Whole Foods shares have already tripled in 2009 makes many analysts reluctant to recommend the stock at this price. "There's a lot of expectation built into the stock," Wolf says, with investors apparently predicting "a pretty bright future."

Noting that shares trade at more than 20 times his 2010 earnings estimate, JPMorgan (JPM) analyst Charles Grom said: "The stock is extremely rich, in our view."

For now, Whole Foods is trying to do what it can to increase profits in a downturn. Its strategies include careful discounting, cost-cutting, and trying to educate the public on the value of its organic, natural offerings.

But the chain's long-term prospects overwhelmingly depend on something that's very hard to predict or control: the direction of the economy and the ability of consumers to open their wallets again.